Unilever, Kraft Heinz and swimming with sharks

27.02.17 Editorial
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Unilever is conducting a comprehensive review of options available to accelerate delivery of value for the benefit of our shareholders. The events of the last week have highlighted the need to capture more quickly the value we see in Unilever. We expect the review to be completed by early April, after which we will communicate further.

Unilever press release 22.02.2017

The entire food industry is "3G-ing" itself before Kraft Heinz can do it to the companies.

It took only 48 hours for Unilever to fight off a USD 143 billion Kraft Heinz takeover bid; the shock waves will reverberate far longer at Unilever and beyond. By using Kraft Heinz as the vehicle to swallow whole a far larger company, private equity investors 3G Capital - the driving force at Kraft Heinz, AB InBev and Burger King - have again demonstrated the scale of their imprint on the food industry and 'fast-moving consumer goods' sector as a whole.

3G's financial and operational methods have ratcheted up financial demands on the food industry by setting previously unimaginable returns on operating margins as the new investor benchmark. Kraft Heinz claims margins in excess of 20 percent and is luring investors with promises of even higher. Competitors which fail to hit the target, or move too slowly, are instantly punished. The penalty is lower investor returns via an attack on the share price, or death through takeover.

How do they squeeze these margins out of a bottle of ketchup or a can of beer? Where the traditional leveraged buyout operation funds acquisitions through debt, vacuums out money and disposes of the investment, 3G borrows, buys and relentlessly cuts costs while holding on to the acquired company. 3G then makes a major new acquisition before margin growth is threatened by the need for new investment to fund real growth. The new acquisition funds continued margin growth through a new round of factory closures and payroll reduction, and the bigger, leaner company then uses its enhanced muscle with retailers and suppliers. And prepares to swallow another competitor.

The formula requires constant movement: Fortune magazine calls it "Buy, squeeze, repeat." "It's like the shark that can't stop swimming," a leading food industry executive told Fortune. It succeeds brilliantly in financial markets geared to short-term results. Operating margins record a company's operating income per unit of sales revenue. For 3G, it is a measure of their ability to pay down debt - and fund the next acquisition. The company's share price continues to inflate relative to actual earnings on the expectation of future mega-returns through new acquisitions. What the 3G model cannot do is build long-term growth through research and investment, which are, of course, costs, and costs, as one of 3G's Brazilian founders famously remarked, "Are like fingernails: they have to be constantly cut."

The shark must not only keep swimming. 3G's hungry capital must continually increase its speed and its caloric intake. In 1999 the founders of what  was to become 3G merged their Brazilian brewing operations to form AmBev. AmBev bought Belgian-based Interbrew in 2004 to create InBev. InBev bought US-based Anheuser-Busch in 2008 for USD 52 billion to create AB InBev. AB InBev swallowed SABMiller in late 2015 for USD 107 billion in cash.

In 2013, 3G teamed with Warren Buffett's Berkshire Hathaway to take Heinz private in a highly leveraged USD 28 billion buyout; less than 2 years later, Buffett and 3G merged the Kraft Foods Group with Heinz in a deal which valued Kraft at over USD 46 billion.

The 3G formula requires abundant debt at low interest rates, compliant competition authorities, tax regimes that favor debt over equity and governments that subsidize job destruction. In Davenport, Iowa, Kraft Heinz is receiving a USD 4.7 million gift for a new factory which will employ only one-third of the workers as the older facility it is closing there. Massive social destruction is built into the model.

3G built a Brazilian brewer into global giant AB InBev through layoffs and ruthless cost-cutting, and managed to squeeze even more cash out of Burger King when they took over from an earlier private equity consortium. In the 20 months following the 3G/Berkshire Hathaway leveraged buyout of Heinz, the company eliminated 23 percent of the global workforce through closures, restructuring and casualization. Operating margins increased by 4.5 percent. Investors loved it.

The Kraft Heinz bid for Unilever, if successful, would have been the third-largest takeover in corporate history. While the offer was in combined cash and shares, cash would have made up over USD 87 billion of the total. The Unilever which would have emerged would be saddled with the debt and subject to extraordinary cost pressures. It would be unrecognizable.

Unlike 3G's portfolio companies, which have slashed investment to the bone, Unilever over the past 6 years has been increasing capital expenditure, insourcing previously outsourced production and reducing the incidence of casual employment. Pressure on the workforce has grown, as it has grown everywhere under the pressure of financial markets, but Unilever recognizes the IUF, has publicly committed to respecting trade union rights and backed its commitment by seriously engaging with the IUF at corporate and local level. This engagement, along with many thousands of jobs (and the company's 'Sustainable Living Plan), would be among the first casualties of a 3G takeover.

Unilever may have fought off - for now - the immediate threat of a 3G takeover, but the 3G effect looms over Unilever's "comprehensive review of options available to accelerate delivery of value for the benefit of our shareholders." Financial analysts have for many years been pressuring Unilever to divest its sizeable spreads division, despite its significant contribution to the company's cash flow and profits. The takeover shock will revive talk of splitting foods and home and personal care products. Whatever emerges, unions will have to be organized and prepared to fight.